A few weeks ago, I showed you three ways emotions can cost you big in investing.
So now… I’m going to tell you about three more emotional responses to watch out for – and how to overcome them – when you invest…
1. Confirmation bias
Everyone likes being proven correct. Most people look for information and insight to confirm what they already believe – and avoid information that challenges their pre-existing beliefs. Often, even less-than-clear evidence is used to support what people believe.
This is called confirmation bias (or “my-side bias,” or “verification bias”). It shows up in many ways, including how people research investment opportunities.
For example, an investor may believe a particular stock is headed higher, so he’s drawn to evidence that confirms that view. And he ignores or plays down the significance of data that doesn’t support his view. Our brains look for ways to confirm what we already believe.
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Confirmation bias is everywhere in politics. Those on one side of the political spectrum tend to look only at news and information that supports their pre-existing beliefs. Those on another side only consider news and insight that support their political positions. Both groups typically ignore evidence supporting the other side.
So how can you overcome confirmation bias?
The first step is to recognise that your brain is programming you to confirm your own beliefs. Once you realise this, it’s a question of actively seeking out information that goes against what you believe and understand. Find a view that’s contrary to your own and think about it for a while.
You may – actually, you probably will – wind up sticking with what you believe. But your investment decisions may benefit from a conscious effort to deal with this bias.
2. The bandwagon effect
When it comes to investing, your parents may have given you the best advice (though in a different context): “If everyone else was jumping off a cliff, would you do the same?”
People tend to follow the herd. We think if everyone else is doing something, then it must be the right thing to do. But there is often no good, rational reason for doing what everyone else is doing.
This bandwagon effect is what happens when you do what others do without making a reasoned, objective decision on your own.
Investors feel better about their decision when many others are doing the same thing. That often happens when a stock’s price begins to rise. Everyone buys the stock, then others take notice and do the same.
Similarly, when an asset price starts to fall, the crowd rushes for the door, fearing heavy losses. So you panic and sell, too.
The bandwagon effect clouds our judgment about specific investments and prevents us from thinking clearly when analysing an investment. If you follow the herd into inflated markets without forming your own informed opinion, you’re likely in for a rude surprise when the bubble bursts.
Some of the best investment decisions are those that go against the grain. This is contrarian investing – you buy when the crowd is bearish and you sell when everyone else is bullish.
And as your parents said, just because everyone else is doing it does not mean it’s the smart thing to do.
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3. The seersucker illusion
In the investment world, as in every field, there are experts who can give you good advice and guidance. But relying too much on “experts” can sometimes be just as bad as investing blindly. That’s because no one, not even (or especially) experts, is right all of the time, or even most of the time.
Over-reliance on experts is often called the seersucker illusion, from the expression “For every seer, there is a sucker.” People fall victim to it even though the average market “seer” or expert has a horrible track record of accurately predicting what will happen in the markets. So if you rely only on investor reports or broker recommendations, it’s likely you will lose money over time.
There’s a role for financial advisors for certain investors. But it’s important to think for yourself and not put too much faith in experts.
Don’t be a sucker. You may get excellent advice from people you trust and respect, but make sure you form your own opinions as well. If you are looking for expert advice, try consulting more than one expert, especially ones with different viewpoints.
Publisher, Stansberry Pacific Research